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You are here:  FE Trustnet     Education        Structured Products

Structured Products


What makes a structured product?
As we have noted above, each structured product is tailored to meet a particular set of circumstances. The offering can be as simple as a bond deposit with one bolt-on feature. This is a way of protecting your initial outlay while still plugging in to the possibility of it earning more than the APR on your building society account. Let's see how this might happen:

Common Features
In its simplest form, a product will be a time-circumscribed deposit with a provider, who will invest it in at least two underlying assets designed to provide:
- a degree of capital protection, from a risk-free deposit that is guaranteed to return all, or a proportion of, the investor's initial outlay,
- growth or income potential from a riskier underlying asset.
How they work: the basic structure
The investors' money is treated in two ways: firstly, the provider will use the major proportion of it to buy a zero coupon bond. The bond is intended to return a fixed amount at a specified point in the future, and that amount can be set to match the investors' original investment, or a proportion of it. This is the capital protection element of the product.
Since the bond is 'zero coupon', i.e. it will not pay any interest in return for the use of the investors' money during its lifetime, the amount required to secure the level of eventual return is worth less in today's terms. This 'present value' of the future return will vary according to the period involved and prevailing interest rates - the longer the period and the higher the rates, the lower is the cost of the bond that provides capital protection. This leaves a residue from the total sum invested. So, secondly, the product provider uses this residue to buy the other, income- or growth-producing, component in the structure.
This component will be a form of participation in a market which is intended to produce higher potential returns than would be available from 'risk-free', fixed interest investments. The availability of financial derivatives means that the providers' research teams can take an informed view on how markets are likely to perform in the future, and place a bet on that view. If they're right they make money; if they're wrong the capital invested is still protected to a greater or lesser extent. The bet is called an option.
The two best known forms of option are 'put', and 'call'. An option confers a time-limited right, but not a legal obligation, to trade in an asset, whether it be indices, like the FTSE 100, equities or some other instrument with a quantifiable market value.
Put Options: If a provider takes the view that, say, Vodafone shares are destined to lose value over the period of the structured product's life, they will use the residual investment fund to buy a put option from an investment bank. The option establishes a 'strike' price at which the option seller must buy a predetermined number of Vodafone shares upon maturity of the option. If the Structured product provider is correct in its forecast, it will acquire the shares necessary to complete the contract more cheaply than the strike price, and sell them to the investment bank at a profit.
Call Options:
Now assume that, to remain with our example, it is believed that Vodafone shares are going to rise in value over the period. With a call option, the owner has the right to buy Vodafone at the strike price. With the market value higher than the exercise price, the shares are bought under the option then sold at a profit in the open market.
The institutions who offer these options clearly need to make their own profits, and a premium is charged on each contract they sell. There is also the possibility that the option will not be exercised: this possibility increases with the narrowness between the market price and the strike price after fees.
These two elements are the basic components of a simple structured product. The provider will vary the proportions of capital protection and market participation to offer a specific risk/return profile. Essentially, the more capital protection, the less upside participation will be offered.
Variants designed for specific outcomes
For ease of explanation, our options examples above used a single stock as an illustration, but the underlying asset in a simple product is more likely to be an index, such as the FTSE 100.
In this earlier guise, the added-value component of the structures tended to be straightforward directional bets: will the underlying asset go up or down? Now, with more creative design and an accent on the benefits of asset allocation, providers are mixing asset types to reduce volatility, and to counter downside with a corresponding upside elsewhere.
So, while the FTSE 100 has been a commonly-used asset in these products, the index is weighted, and dominated by companies in four sectors: telecoms, banks, oil and pharmaceuticals. This does not do much for diversification, and there is now a trend towards combining a proportion of FTSE 100 exposure with participation in another investible index, such as the S&P 500, or the Eurostoxx 50.
Also, other underlying assets of different types are being used in combination, and assets not available to conventional onshore funds are increasingly making an appearance. There are now products tailored to invest in a specific basket of equities, in commodities, foreign exchange and hedge funds.
Then, while most of these products have fixed terms, a new breed is gradually becoming familiar, in which a 'kick-out' clause is invoked to terminate the scheme when its return objectives have been met. So, although these schemes carry a nominal maximum period, they have the option of closing and paying back their investors if they have done particularly well, and achieved their projected returns earlier than expected.
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